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International Financial System 1

2 Foreign Exchange

Foreign Exchange

FIRST EDITION : 2011

MUMBAI NEW DELHI NAGPUR BENGALURU HYDERABAD CHENNAI PUNE LUCKNOW AHMEDABAD ERNAKULAM BHUBANESWAR INDORE KOLKATA GUWAHATI

Dr. P. G. Gopalakrishnan

Mrs. Nandini Jagannarayan

Principal, S.I.W.S. College, Wadala, Mumbai.

Lecturer, B. Com. (Banking & Insurance),Ramniranjan Jhunjhunwala College,

Ghatkopar, Mumbai.


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First Edition : 2011

4 Foreign Exchange

Preface

The authors have made an earnest to present this book on Foreign Exchange to presentall major subjects in international monetary theory, foreign exchange markets, internationalfinancial management and investment analysis in a lucid manner. The book is relevant toreal world problems in the sense that it provides guidance on how to solve policy issues aswell as practical management tasks. This in turn helps the reader to gain a basic understandingof the theory and refines the framework.

The book is intended for the students of Mumbai University pursuing their Third YearB.Com. (Financial Markets) and can be used in other graduate and advanced undergraduateprogrammes in international or global finance, international monetary economics, andinternational financial management.

Subjects covered include:

Foreign exchange markets and foreign exchange rates

Exchange rate regimes and international monetary systems

International parity conditions

Balance of payments and international investment positions

Open economy macroeconomics

Balance of payments issues and exchange rate movements

Global derivatives markets

Derivative financial instruments for foreign exchange risk management: currencyfutures, currency options, and currency swaps

Measurement and management of transaction exposure, economic exposure andaccounting exposure

Country risk analysis and sovereign risk analysis

Foreign direct investment and international portfolio investment

The authors thank all those enabled in realising the book in the present form and morespecifically Dr. (Mrs.) Usha Mukundan, Principal, Ramniranjan Jhunjhunwala College,Mumbai and host of well-wishers, friends and colleagues and the publishers, M/s. HimalayaPublishing House.

We would like to extend our Sincere thanks to the production team for having ConstantlySupported us when we were on with this three books: Foreign Exchange, FinancialAccounting and Derivative Markets

-Dr. P.G.Gopalakrishnan

-Mrs. Nandini Jagannarayan


Contents

Chapter Page

1. International Financial System 1-26

2. Balance of Payments 27-53

3. Foreign Exchange Market Theory 54-70

4. Failure of Bretton Woods Conference 71-81

5. Concepts in Foreign Exchange Market and Basic Arithmetic 82-129

6. Foreign Exchange Market in India 130-145

7. Foreign Exchange Trades Settlement in India 146-154

8. Foreign Exchange Risk and Exposure 155-163

9. Futures and Options 164-198

10. Capital Account Convertibility [CAC] 199-201

11. Eurocurrency Market 202-210

12. Regulatory Framework 211-225

Bibliography 226

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Chapter Objectives:

To study the different types of equity and debt instruments in the international capitalmarket.

Chapter Contents

International Institutions

Equity Instruments

Depository Receipts

Debt Instruments

Syndication of Loans

International Bond Market

Quasi Instruments

Chapter 1

International Financial System


The International Financial System (IFS) is the financial system consisting of institutionsand regulators that act on the international level, as opposed to those that act on a nationalor regional level. The main players are the global institutions, such as International MonetaryFund and Bank for International Settlements, national agencies and government departments,e.g., central banks and finance ministries, private institutions acting on the global scale, e.g.,banks and hedge funds, and regional institutions, e.g., the Eurozone.

International InstitutionsThe most prominent international institutions are the IMF, the World Bank and the

WTO:

The International Monetary Fund keeps account of international balance of paymentsaccounts of member states. The IMF acts as a lender of last resort for members infinancial distress, e.g., currency crisis, problems meeting balance of payment whenin deficit and debt default. Membership is based on quotas, or the amount of moneya country provides to the fund relative to the size of its role in the internationaltrading system.

The World Bank aims to provide funding, take up credit risk or offer favourableterms to development projects mostly in developing countries that couldn’t be obtainedby the private sector. The other multilateral development banks and otherinternational financial institutions also play specific regional or functional roles.

The World Trade Organisation settles trade disputes and negotiates internationaltrade agreements in its rounds of talks (currently the Doha Round).

Also important is the Bank for International Settlements, the intergovernmentalorganisation for central banks worldwide. It has two subsidiary bodies that are importantactors in the global financial system in their own right — the Basel Committee on BankingSupervision, and the Financial Stability Board.

In the private sector, an important organisation is the Institute of International Finance,which includes most of the world’s largest commercial banks and investment banks.

International financial markets and operations comprise exchange deals, i.e., buying,selling currencies, banking transactions, i.e., deposit taking and lending, and capitalmarket operations, i.e., issuance of securities. However, market segments are classifiedaccording to nature of financial operations.

Money markets: exchange or exchange-related transactions.

Credit market: deposit taking and lending.

Capital markets: issuance of securities.

Equity markets: issuance of international securities.

In finance, the money market is the global financial market for short-term borrowingand lending. It provides short-term liquid funding for the global financial system.

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The money market consists of financial institutions and dealers in money or credit whowish to either borrow or lend. Participants borrow and lend for short periods of time, typicallyup to thirteen months.

The core money market consists of banks borrowing and lending to each other, usingcommercial paper, repurchase agreements and similar instruments. These instruments areoften benchmarked to LIBOR.

Finance companies such as GMAC typically fund themselves by issuing large amountsof asset-backed commercial paper (ABCP) which is secured by the pledge of eligible assetsinto an ABCP conduit.

Certain large corporations with strong credit ratings, such as General Electric, issuecommercial paper on their own credit. Other large corporations arrange for banks to issuecommercial paper on their behalf via commercial paper lines.

In the United States, federal, state and local governments — all issue paper to meetfunding needs. States and local governments issue municipal paper, while the US Treasuryissues Treasury bills to fund the US public debt.

Common money market instruments:

Euro notes and Euro commercial papers.

Bankers’ acceptance and Letters of credit.

Repurchase agreements.

Eurodollars.

Federal funds.

Municipal notes.

Treasury bills.

Money funds.

Certificate of deposits.

Floating rate notes.

Euro bonds.

Debt InstrumentsA. Syndication of loans: As the size of Indian loans increased, Indian banks found it

difficult to take the risk singly. Regulatory authorities in most countries also limit the size ofindividual exposures.

This has led to two practices “Club Loans” and “Syndicated loans”.

Under Club loans, are a small group of banks joining together to form a club and givethe loan.


Syndicated loans are lead manager, or group syndicate the loan by inviting participationof other banks. Traditionally, major commercial banks were lead managers. Lately, however,investment banks like Merill Lynch and Morgan Stanly have been active in the field. In largeloans, the syndicate can comprise several hundred banks.

Given that syndicated loans can be quickly arranged, these have become the main sourceof financing for corporate acquisition.

Fees payable— Syndicated loans include a management fee (payable by the borrowereither on loan signing or on first drawdown), commitment fee (payable on the underwrittenportion of the loan during the availability period) and agency fee (payable to the agent bankto cover administration costs incurred during the currency of the loans).

Syndicated medium term credits are not necessarily availed to finance projects. Manycountries have used the proceeds for general balance of payment purposes, to finance domesticbudget deficits or to finance existing external debt.

Syndication of LoansThe size of loan is large, individual banks cannot or will not be able to finance singly.

They would prefer to spread the risk among a number of banks or a group of banks is called‘Syndication of Loans’. These days, there are large group of banks that form Syndicates toarrange huge amount of loans for corporate borrowers — the corporate that would want aloan but not be aware of those banks willing to lend. Hence, Syndication plays a vital rolehere. Once the borrower has decided upon the size of the loan, he prepares an informationmemorandum containing information about the borrower disclosing his financial positionand such other information like the amount he requires, the purpose, business details of hiscountry and its economy. Then he receives bids (after this, the borrower and the lenders sitacross the table to discuss about the terms and conditions of lending this process of negotiationis called ‘syndication’). The process of syndication starts with an invitation for bids from theborrower. The borrower then mention the fund requirement, currency, tenor, etc. The mandateis given to a particular bank or institution that will take the responsibility of syndicating theloan while arranging the financing banks.

Syndication is done on a best effort basis or on underwriting basis. It is usually the leadmanager who acts as the syndicator of loans, the lead manager has dual tasks that is, formationof syndicate documentation and loan agreement. Common documentation is signed by theparticipating banks or common terms and conditions. Thus, the advantages of the syndicatedloans are the size of the loan, speed and certainty of funds, maturity profile of the loan,flexibility in repayment, lower cost of fund, diversity of currency, simpler banking relationshipand possibility of re-negotiation.Steps Involved in Loan Syndication:

1. The borrower decides about the size and currency of the loan he desires to borrowand approaches banks for arranging the financing on the basis of business, purposeof the loan, etc.

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2. For a name acceptable in the market, in general several banks or group of banks willcome forward with offers indicating broad terms on which they are willing to arrangethe loan. The bank offers to be the Lead Manager. In their offers, the lead managerwould indicate the loan and its commitment and other charges and spreads overLIBOR on which they are willing to arrange the loan.

3. The borrower chooses the bid which appears to be the best to him in terms of thetotal cost of the package, other terms and conditions and the relationship factor, etc.on receiving the bid from various banks or groups of banks.

4. The loan gets finalised by both the borrower and the lenders on an informationmemorandum giving financial details and other details of the borrower. The leadmanager would participate in the loan from lenders based on the informationmemorandum.

5. The entire fees would be showed by the participating bank (based on theirparticipation) and lead manager.

6. The lead manager are liable to finance the balance amount is known.

7. The next step in finalisation of the loan agreement by borrowers and lender is doneafter the participants are known and the loan is published through a financial press.

The important provision of a loan agreement:

1. The loan agreement specifies the interest, commitment fees and the management feesthat the borrower should pay to the lender.

2. Document pertaining to borrower’s financial position, overrun finance agreement,got approvals received (for e.g., Relating to tax, reduction at sources) tying up ofother financial requirement (if required), certificates from lawyers, and other internaland external approval that would be required.

3. The primary or the secondary security against which the loan is taken will have tobe decided.

4. The circumstances that are to be treated as default and suit against the borrowerwhen the borrower is not servicing the loan, cross default clauses (aimed at givingthe lenders the right to accelerate repayment of the loan in the event of the borroweror guarantor is in default under any loan agreement) etc. are decided.

5. Jurisdiction is an important element of any international loan agreement and it tellswhich country’s law is applicable.

Advantages Syndicated loan facilities can increase competition for your business, prompting other

banks to increase their efforts to put market information in front of you in hopes ofbeing recognised.


Flexibility in structure and pricing. Borrowers have a variety of options in shapingtheir syndicated loan, including multicurrency options, risk management techniques,and prepayment rights without penalty.

Syndicated facilities bring businesses the best prices in aggregate and spare companiesthe time and effort of negotiating individually with each bank.

Loan terms can be abbreviated.

Increased feedback. Syndicate banks sometimes are willing to share perspectives onbusiness issues with the agent that they would be reluctant to share with theborrowing business.

Syndicated loans bring the borrower greater visibility in the open market. Bunnnoted that “For commercial paper issuers, rating agencies view a multi-year syndicatedfacility as stronger support than several bilateral one-year lines of credit.”

Why a syndicated loan?

Lenders both banks and institutional providers tightened their belts for a couple ofyears, deals to minimise their risk or exposure. While lenders today may be cash-heavy, theyare not looking to throw cash at every deal that crosses their desks.

Lenders may be reluctant to hold large amounts of debt from a single corporate customer,opting instead to take a piece of the deal and syndicating the remainder to other banks orinstitutional lenders. This strategy spreads the risk or exposure among multiple lenders. Theborrower, benefits by increasing the borrowing capacity with multiple credit providers. Andthere are additional benefits.

Less-expensive financing than bonds, lower interest rates and upfront costs.

Prepayment may be available without penalty or premium.

Expanded access to non-credit products such as capital markets solutions and expertise.

Syndicated Loan MarketsSyndicated Loans are international in their understanding, although certain geographical

regions maintain unique attributes. The broad international markets are North America,EMEA and Asia. Within Asia, based upon size and volume of loans, Japan is often singledout as a significant market.

The syndicated loan market could be roughly divided into two “classes” of syndicatedloans. The first, designed for smaller companies (loan sizes approximately between 20 to 250million), feature funds usually lent by a fixed group of banks for a fixed amount. In NorthAmerica and Europe, larger loans than this are often open to be traded, so that they almostbecome more like a regular bond. Purchasers of these loans include hedge funds, pensionfunds, banks, and other investment vehicles. Asian markets have limited numbers of loansthat are freely traded this way.

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The second, until the subprime lending crisis, larger syndicated loans, although“agented” by one bank, were often sold to the international capital markets after repackaginginto trusts and being sold as collateralised loan obligations. For larger loans, there wassome evidence that the agent banks would often underwrite portions of these loansspecifically for onselling as collateralised loan obligations. This underwriting may havebeen in excess of the broader expected appetite of traditional lenders. With the collapse ofmany aspects of the international fixed income (lending) capital markets due to the subprimecrisis, many banks were stuck with underwritten positions, potentially on terms theywould not have lent on for the entire stated period of the business loan. These are knownas “hung” or “stuck” underwrites or loans and have been responsible for a portion of therecent losses of financial institutions.

Foreign BorrowingsForeign borrowings can be classified under club loans and syndicate loans explained

above in earlier pages.

Euro Notes and Euro Commercial PapersBoth Euro notes and Euro commercial papers are short-term instruments, unsecured

promissory notes issued by corporations and banks. Euro notes, the more general term,encompasses note- issuance facilities, those that are underwritten, as well as those are notunderwritten. The term Euro commercial papers is generally taken to mean notes that areissued without being backed by underwriting facility – that is without the support of mediumterm group of banks to provide funds in events that ate borrower is unable to role over itsEuro notes on acceptable terms. These Euro Commercial papers are an unsecured, short-term loan issued by a bank or corporation in the international money market, denominatedin a currency that differs from the corporation’s domestic currency.

For example, if a US corporation issues a short-term bond denominated in Canadiandollars to finance its inventory through the international money market, it has issued eurocommercial paper.

CP represents a cheap and flexible sources of fund while CP are negotiable, secondarymarket lend to be not very active and most investor hold the paper to maturity. The rates ofinterest are cheaper than bank looks and this instrument is issued only by high ratedborrowers. Euro Commercial paper has emerged only very recently. Commercial paper is amoney market security issued by large banks and corporations. It is generally not used tofinance long-term investments but rather to purchase inventory or to manage working capital.Because commercial paper maturities do not exceed nine months and proceeds typically areused only for current transactions, the notes are exempt from registration as securities withthe United States Securities and Exchange Commission.


Banker’s Acceptance and Letters of CreditA bankers’ acceptance, or BA, is a time draft drawn on and accepted by a bank. It is a

time draft drawn on and accepted by a bank. Before acceptance, the draft is not an obligationof the bank; it is merely an order by the drawer to the bank to pay a specified sum of moneyon a specified date to a named person or to the bearer of the draft. Upon acceptance, whichoccurs when an authorised bank accepts and signs it, the draft becomes a primary andunconditional liability of the bank. If the bank is well-known and enjoys a good reputation,the accepted draft may be readily sold in an active market. A banker’s acceptance is also amoney market instrument – a short-term discount instrument that usually arises in thecourse of international trade.

A banker’s acceptance starts as an order to a bank by a bank’s customer to pay a sum ofmoney at a future date, typically within six months. At this stage, it is like a postdated check.When the bank endorses the order for payment as “accepted”, it assumes responsibility forultimate payment to the holder of the acceptance. At this point, the acceptance may be traded insecondary markets much like any other claim on the bank. Bankers’ acceptances are consideredvery safe assets, as they allow traders to substitute the banks’ credit standing for their own.They are used widely in international trade where the creditworthiness of one trader is unknownto the trading partner. Acceptances sell at a discount from face value of the payment order, justas US Treasury bills are issued and trade at a discount from par value.

Acceptances arise most often in connection with international trade. For example, anAmerican importer may request acceptance financing from its bank when, as is frequentlythe case in international trade, it does not have a close relationship with and cannot obtainfinancing from the exporter it is dealing with. Once the importer and bank have completedan acceptance agreement, in which the bank agrees to accept drafts for the importer and theimporter agrees to repay any drafts the bank accepts, the importer draws a time draft on thebank. The bank accepts the draft and discounts it; that is, it gives the importer cash for thedraft but gives it an amount less than the face value of the draft. The importer uses theproceeds to pay the exporter.

The bank may hold the acceptance in its portfolio or it may sell, or rediscount, it in thesecondary market. In the former case, the bank is making a loan to the importer; in the lattercase, it is in effect substituting its credit for that of the importer, enabling the importer toborrow in the money market. On or before the maturity date, the importer pays the bank theface value of the acceptance. If the bank rediscounted the acceptance in the market, the bankpays the holder of the acceptance the face value on the maturity date.

Letters of credit are documents issued by banks in which the bank promises to pay acertain amount on a certain date, if and only if documents are presented to bank as specifiedin terms of the credit. A letter of credit is generally regarded as a very strong legal commitmenton the part of banks specified in terms of letters of credit. In typical export transactions, theexporter will want to be paid once the goods arrive in foreign port. So, the exporter asks foracceptance of importers bank of time draft and that essentially would be an invoice thatrequests a money market instruments.

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Repurchase Agreement Repurchase agreements (RPs or repos) are financial instruments used in the money

markets and capital markets. A more accurate and descriptive term is Sale andRepurchase Agreement — cash receiver (seller) sells securities now, in return forcash, to the cash provider (buyer), and agrees to repurchase those securities from thebuyer for a greater sum of cash at some later date, that greater sum being all of thecash lent and some extra cash (constituting interest, known as the repo rate).

A reverse repo is simply a repurchase agreement as described from the buyer’sviewpoint, not the seller’s. Hence, the seller executing the transaction would describeit as a ‘repo’, while the buyer in the same transaction would describe it a ‘reverserepo’. So, ‘repo’ and ‘reverse repo’ are exactly the same kind of transaction, justdescribed from opposite viewpoints.

A repo is economically similar to a secured loan, with the buyer receiving securitiesas collateral to protect against default. However, the legal title to the securities clearlypasses from the seller to the buyer, or “investor”.

Although the underlying nature of the transaction is that of a loan, the terminologydiffers from that used when talking of loans due to the fact that the seller does actuallyrepurchase the legal ownership of the securities from the buyer at the end of theagreement. So, although the actual effect of the whole transaction is identical to acash loan, in using the ‘repurchase’ terminology, the emphasis is placed upon thecurrent legal ownership of the collateral securities by the respective parties.

Although repos are typically short-term, it is not unusual to see repos with a maturityas long as two years.

Money Market Instruments Eurodollars

Treasury securities

Federal bonds

Municipal bonds.

Eurodollars

US dollars held as deposits in foreign banks

Corporations often find it more convenient to hold deposits at foreign banks tofacilitate payments in their foreign operations

Can be held in US bank branches or foreign banks

Dollar denominated deposits are referred to as Eurodollars


Risk

They are not subject to reserve requirements

Nor are they eligible for FDIC depositor insurance (US government is not interestedin protecting foreign depositors)

The resulting rates paid on Eurodollars are higher (higher risk)

Trading

Overnight trading as in the Federal Funds market

Eurodollars are traded in London, and the rates offered are referred to as LIBOR(London Interbank Offered Rate)

Rates are tied closely to the Fed Funds rate Should the LIBOR rate drop relative to the Fed Funds rate, US banks can balance

their reserves in the Eurodollar market (arbitrage)Treasury Securities

Issued by Federal Government: Finance annual deficits (budget shortfalls) Refinance maturing debt

Standard maturities: 4, 13, 26 or 52 weeks (1, 3, 6, 12 months)

Interest rate: No coupon payment T-bills sold at a discount to face value (implied rate of return) Four types of treasury securities Treasury Bills Treasury Notes Treasury Bonds Savings Bonds

Treasury Bills

T-bills are short-term securities issued by the US Treasury.

T-bills mature in one year or less (usually 28, 91, and 182 days).

Banks and financial institutions are the largest purchasers of T-bills.

Yield (%) = (face value – purchase price/purchase price) * (360/days till maturity)

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Treasury Notes

Treasury Notes mature in 2 to 10 years.

They have coupon payment every six months.

Commonly issued with maturities dates of 2, 5, 10 years, for denominations from$1000 to $1000000.

Treasury Bonds (T-bonds or the Long Bonds)

Have longest maturity from 10 to 30 years.

Have coupon payments every six months.

Savings Bonds

Are Treasury Securities for individual investors.

These are registered, no callable bond issued by the US government and are backedby its full faith and credit.

There is no active secondary market for savings bonds.

Saving Bonds do not have coupons.

Federal Funds

Short-term funds transferred (loaned or borrowed) between financial institutions,usually for a period of one day.

Used by banks to meet short-term needs to meet reserve requirements (overnight).

Banks loan because they would not make any interest at all on excess reserves heldwith the Fed.

Banks may borrow the funds to meet the reserves required to back their deposits.

Participants in federal funds market include commercial banks, savings and loanassociations, government sponsored enterprises, branches of foreign banks in theUS, federal agencies and securities firms.

Municipal Bonds

Bond issues by a state, city, or other local government or their agencies.

The method and practices of issuing debt are governed by an extensive system oflaws and regulations, which vary by state.

The issuer of the municipal bond receive a cash payment at the time of issuance inexchange for a promise too repay the investor over time.

Repayment period can be as short as few months to 20, 30, 40 years or even longer.


Bond bear interest at either fixed or variable rate of interest.

Interest income received by bond holders is often exempt from the federal income taxand income tax of state.

Investors usually accept lower interest payments than other types of borrowing.

Municipal bond holders may purchase bonds either directly from the issuer at thetime of issuance or from other bond holders after issuance.

Municipal bonds typically pay interest semi-annually.

Interest earnings on bonds that fund projects that are constructed for the publicgood are generally exempt from federal income tax.

But, not all municipal bonds are tax-exempt.

Municipal bonds may be general obligations of issuer or secured by specified revenues.

Certificate of DepositA certificate of deposit (CD) is a money market instrument issued by a depository

institution as evidence of a time deposit. Small denomination certificates of deposit are issuedto retail investors. In the United States, these usually are covered by deposit insurance. Largedenomination certificates of deposit are issued to institutional investors for denominationsgenerally exceeding USD 1.0MM.

A certificate of deposit has a fixed term. At the end of the term, the deposit is returnedwith interest. The vast majority of certificates of deposit have terms of under a year, withthree months being typical. Certificates of deposit with terms of a year or more are calledterm CDs. Terms of five years are not unheard of.

Most certificates of deposit credit a fixed rate of interest, but there are also floating-ratecertificates of deposit. A fee must be paid to withdraw funds early. Because most certificates ofdeposit are negotiable, investors usually sell an unwanted certificate of deposit rather thanpay a fee and withdraw the funds. To facilitate transferability, most certificates of deposit areissued in bearer form, but some are registered.

Euro CDs are issued outside a country but are denominated in that country’s currency.

Domestic and foreign CDs are subject to the regulations of the country in which theyare issued. Euro CDs are not regulated and for this reason, Euro CDs have historicallyoffered slightly higher yields.

In short

A certificate of deposit is a promissory note issued by a bank or a credit union.

The insurer are FDIC or NCUA.

Usually, a fixed interest rate is paid by the institution.

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Rates

General rules for interest rates

The larger the principal, the higher the interest

The longer the term, higher the interest

The smaller the bank the higher the interest

Working

A passbook is received by the purchaser

No certificate as such

At maturity the investors are informed

Callback option

Ladder

To get lock in with the interest rates of rising rates of economy ladder strategy ispracticed

Invest diversifiable

International Bond Market

B. BondsBonds are IOUs issued by both public and private entities to cover a variety of expenses.

For investors, bonds provide a cushion of stability against the unpredictability of stocks andshould be a part of almost every portfolio.

In many, but not all, markets, bonds will move in the opposite direction of stocks. Ifstocks are up, bonds are down and if stocks are down, bonds are up. This is a very broadgeneralisation, but one that helps explain why bonds are a good counter to stocks.

You have a wide variety of bonds to choose from and each type has certain characteristics.

In the 19th century, foreign issuers of bonds, mainly government and railway companies,used the London market to raise finances. Foreign bonds are bonds floated in the domesticmarket (currency from non-resident entities). As controls over movement of capital,government related, many foreign bonds were issued in the domestic markets of the USA,UK, Germany, Japan Netherlands, Switzerland, etc. Modern Jargon refers to these as Yankeebonds, i.e., those issued in the USA, domestic market, Bulldog bonds in UK, Samurai bondsin Japan, etc. Offshore bonds which were formally known as Euro bonds are bonds issuedand sold outside the home country of the currency of issue, e.g., A dollar bond sold inEurope is an offshore bond.


Regulatory requirements are less stringent when foreign bond issues are made on privateplacement basis rather than through an invitation to the general public to subscribe.

Euro Bonds A bond underwritten by an international syndicate banks and marketed internationally

in countries other than the country of the currency in which it is denominated is called aEuro bond. This issue is not subject to national restrictions. A detailed discussion on Eurobonds is given below…

Euro bond market is almost free of official regulations.

The Eurobonds are the international bonds which is issued in a currency other thanthe currency or market it is issued.

Generally issued by international sydicate of banks and financial institutions.

Issuer of the Euro Bonds

Usually, a bank specifies the follows:

Desired currency of denomination

The amount

The target rate

Benefits

Small par value and high liquidity

Flexibility to the issuer

For both individual and institutional investors

No impact on Balance of payments

Instruments or Types of Euro Bonds:

(1) Straight Bonds: Bond which will pay back the principal on its maturity date at onestroke called bullet payment, will pay a specified amount of interest on specific dates,and does not carry a conversion privilege or other special features.

(2) Floating Rate Notes: Floating Rate Notes (FRNs) are debt securities bonds, of anycurrency, that entitle the holder to regular interest coupons. FRN coupons are resetperiodically to match the London/Euribor interbank offered rate. Typically, the rateagreed is the benchmark rate plus an addtional spread and is reset every three to sixmonths.

The interest rate is floating and set above or below the LIBOR.

Interest rates are revised every 3-6 months.

20 Foreign Exchange

Contents

Issues

Variations

Risk

Trading

Features of FRNs

The reference rate

The margin

The reference period

Maturity

Some FRNs have special features such as maximum or minimum coupons, called cappedFRNs and floored FRNs. Those with both minimum and maximum coupons are calledcollared FRNs. FRNs can also be obtained synthetically by the combination of a fixed ratebond and an interest rate swap. This combination is known as an Asset Swap.

(3) Flip-flop FRNs: Here, the investors have the option to convert the paper into flatinterest rate instrument at the end of a particular period. World Bank had issuedFRNs with perpetual life and having a spread of 50 basis point over the USA treasuryrate. The investors have the option at the end of 6 months.

(4) Mismatch FRNs: These notes have semi-annual interest payment though the actualrate is fixed monthly. This enables investors to benefit from arbitrage arising out ofdifferential in interest rates for different maturities.

(5) Minimax FRNs: These notes include both minimum and maximum coupons theinvestors will earn the minimum rate as well a maximum rate on these rates.

(6) Zero Coupon Bonds: This is a type of bond that makes no coupon payments butinstead is issued at a considerable discount to par value. For example, let’s say a zerocoupon bond with a $1,000 par value and 10 years to maturity is trading at $600;you’d be paying $600 today for a bond that will be worth $1,000 in 10 years.

Foreign BondsA foreign bond is issued in a domestic market by a foreign entity in the domestic market’s

currency. Bonds are regulated by the domestic market authorities and are usually givennicknames that refer to the domestic market in which they are being offered.

Since investors in foreign bonds are usually the residents of the domestic country, investorsfind them attractive because they can add foreign content to their portfolios without theadded exchange rate exposure.


Types of foreign bonds include bulldog bonds, matilda bonds, and samurai bonds.

(1) Samurai Bonds — A yen-denominated bond issued in Tokyo by a non-Japanesecompany and subject to Japanese regulations. Other types of yen-denominated bondsare Euroyens issued in countries other than Japan.

Samurai bonds give issuers the ability to access investment capital available in Japan.The proceeds from the issuance of samurai bonds can be used by non-Japanese companies tobreak into the Japanese market, or it can be converted into the issuing company’s local currencyto be used on existing operations. Samurai bonds can also be used to hedge foreign exchangerate risk.

(2) Yankee Bonds — A bond-denominated in US dollars and is publicly issued in the USby foreign banks and corporations. According to the Securities Act of 1933, thesebonds must first be registered with the Securities and Exchange Commission(SEC) before they can be sold. Yankee bonds are often issued in tranches and eachoffering can be as large as $1 billion.

Due to the high level of stringent regulations and standards that must be adhered to, itmay take up to 14 weeks (or 3.5 months) for a Yankee bond to be offered to the public. Part ofthe process involves having debt-rating agencies evaluate the creditworthiness of the Yankeebond’s underlying issuer.

Foreign issuers tend to prefer issuing Yankee bonds during times when the US interestrates are low, because this enables the foreign issuer to pay out less money in interest payments.

(3) Bulldog Bonds— Sterling-denominated bond that is issued in London by a companythat is not British. These sterling bonds are referred to as bulldog bonds as the bulldogis a national symbol of England.

(4) Matilda Bonds — An bond-denominated in the Australian dollar and issued on theAustralian market by a foreign entity. It is also known as a “kangaroo bond”. Createdin 1994, the market for matilda bonds is relatively small.

Medium Term Notes (MTNs)A note that usually matures in five to ten years. A corporate note continuously offered

by a company to investors through a dealer. Investors can choose from differing maturities,ranging from nine months to 30 years. Notes range in maturity from one to 10years. By knowing that a note is medium term, investors have an idea of what its maturitywill be when they compare its price to that of other fixed-income securities. All else beingequal, the coupon rate on medium term notes will be higher than those achieved on short-term notes. This type of debt program is used by a company so it can have constant cashflows coming in from its debt issuance; it allows a company to tailor its debt issuance to meetits financing needs. Medium term notes allow a company to register with the SEC only once,instead of every time for differing maturities.

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Note Issuance Facility (NIF)This is a medium term debt instruments which is issued for a short term, usually a year

and can be handed over as and when required. A syndicate of commercial banks that haveagreed to purchase any short to medium term notes that a borrower is unable to sell in theeurocurrency market. This facility under which banks provides credit is called RevolvingUnderwriting Facility (RUF). Interest rates on NIF is said with a spread over LIBOR. Avariation of NIF is the multiple component facility. Here, a borrower is enabled to drawfunds is a number of ways (short-term advances and banker’s acceptance, and of course,opportunities for choosing the maturity and currency).

Equity Instruments Equity Instruments help in increasing the potential demand for the companies share,

there by also increasing its price. Also that it lowers the cost of equity cap and therebyincreases its market value by expanding its investor base. It also gives a brand image for thecompany making the marketing of these shares easy. It also provides liquidity to these shares.

Today, a large number of Indian companies are tapping global financial funds from theforeign market through Euro Issue, viz., Global Depository Receipts (GDRs), AmericanDepository Receipts (ADR), American Depository Shares (ADS) and Foreign CurrencyConvertible Bonds (FCCBs).

Euro IssueThe term ‘Euro issue’ means made abroad through instruments denominated in foreign

currency and listed on a European stock exchange, the subscription for which may comefrom any part of the world. Most of the Indian companies get their issues listed on theLuxembourg Stock Exchange.

Depository ReceiptsThis represents a claim on a specified number of shares. It is denominated in a convertible

currency. The shares issued by a company are held by a international depository. Thisdepository issues depository receipts to the investors and distributes dividend to them. Theissuing company pays dividends in home currency to the depository who in turn converts itinto the currency of investors. Thus, exchange risk here is passed on to a depository. Thename Global Depository Receipt (GDR) implies that more markets than one are tappedsimultaneously. Other names are ADRs and European Depository Receipts (EDRs) and theirreach is limited to American and European markets respectively.


Global Depository Receipts (GDR)A Global Depository Receipt (GDR) is a certificate issued by a depository bank, which

purchases shares of foreign companies and deposits it on the account. GDRs representownership of an underlying number of shares.

Global Depository Receipts facilitate trade of shares, and are commonly used to invest incompanies from developing or emerging markets.

Prices of GDRs are often close to values of related shares, but they are traded and settledindependently of the underlying share.

A GDR is an instrument which allows Indian Corporate, Banks, Non-Banking FinancialCompanies etc., to raise funds through equity issues abroad to augment their resources fordomestic operations. As per the recent guidelines on the issue of GDRs, a corporate entitycan issue any number of GDRs in a year and the Corporate involved in infrastructure projectsneed not have a past track record of financial performance.

Several international banks issue GDRs, such as JPMorgan Chase, Citigroup, DeutscheBank, Bank of New York. They trade on the International Order Book (IOB) of the LondonStock Exchange. Normally, 1 GDR = 10 Shares. A GDR issued in American is an AmericanDepository Receipt (ADR).

Among the Indian Companies, Reliance Industries Ltd. was the first company to raisefunds though a GDR issue.

Features of GDR

1. A GDR holder does not have voting rights.

2. The proceeds are collected in foreign currency thus enabling the issues to utilise thesame for meeting the forex component of project cost, repayment of foreign currencyloans, meeting overseas commitments and for similar other purposes.

3. The exchange risk is lowered in the case of a GDR issue when compared to foreigncurrency borrowing or foreign currency bonds.

4. The GDRs are usually listed at the Luxembourg Stock Exchange as also traded attwo other places besides the place of listing, eg., the OTC market in London and onthe Private Placement market in USA.

5. An investor who wants to cancel his GDR may do so by advising the depository torequest the custodian. The GDR can be cancelled only after a cooling period of 45days. The depository will instruct custodian about cancellation of the GDR and torelease the corresponding shares, collect the sales proceeds and remit the same abroad.

6. Marketing of the GDR issue is done by the underwriters by organising roadshows,which are presentations, made to potential investors. During the roadshows an

24 Foreign Exchange

indication of the investor response is obtained by equity called the “Book Runner”.The issuer finds the range of the issue price and finally decides to the issue price afterassessing the investor response at the roadshows.

Parties Involved in GDR Issue(1) Lead manager: A lead manager is usually an investment bank appointed by the issuing

company. This institution has the responsibility of collecting and evaluatinginformation about the issuing company, documentation and presenting to investorsa current picture of the company’s strengths and future prospects. Lead managersmay involve other managers to subscribe to the issue.

(2) Depository: A depository bank is a bank organised in the United States which providesall the stock transfer and agency services in connection with a depository receiptprogram. This function includes arranging for a custodian to accept deposits ofordinary shares, issuing the negotiable receipts which back up the shares, maintainingthe register of holders to reflect all transfers and exchanges and distributing dividendsin US dollars.

(3) Custodian: An agent that safekeeps securities for its customers and performs relatedcorporate action services. With regard to DRs, the custodian may be the overseasbranch, affiliate or correspondent of the Depository and is responsible for safekeepingof the securities underlying the DRs and performing related corporate actions services.

(4) Clearing system: It is like registrars who keep record of all particulars of GDRs andinvestors. In USA, Depository Trust Company (DTC) does this function. In Europe,there is Euro CLEAR (Brussel’s) – An international clearing organisation, located inBrussels, responsible for holding, clearing and settling international securitiestransactions and similarly CEDEL in (LONDON).

Steps in GDR Issue

Broad steps leading to GDR issue

1. Approval of the Board of the Company for GDRs issue.

2. Appointment of Various Agencies like: Book Runners, Global Coordinators andUnderwriters, International Lawyers, Local/Company’s Lawyers, Auditors andInternational Depository.

3. Organising meetings, management presentations with regard to features and prospectsof GDRs.

4. Commence Financial, Business and Legal attentiveness.

5. Finalise Offer Memorandum (OM).

6. Obtain preliminary listing approval.


7. Print and file Red Herring Offer Memorandum. Submit Red Herring OfferMemorandum to Indian stock exchanges (BSE, NSE) SEBI and Registrar ofCompanies for record purpose.

8. Arranging roadshows for book building.

9. Complete roadshow, signing/pricing meeting and finalisation of allocation to investors.

10. Allotment of underlying shares and GDRs.

11. Closing of all activities.

12. File the final offering document with SEBI and Indian Stock Exchanges.

13. Listing of Shares at the local stock exchanges.

American Depository ReceiptsThese are American version of GDRs. ADRs are negotiable receipts issued to investors

by an authorised depository, normally a US bank or depository, in lieu of shares of theforeign company, which are held by the depository. It is a negotiable instrument, denominatedin the US dollars representing a non-US company’s local currency equity shares. ADRs arelisted on an American stock exchange. The issue process is governed by American laws andSecurities and Exchange Commission (SEC), US, the market regulator, monitors the issue.

An American Depository Receipt (or ADR) represents the ownership in the shares of aforeign company trading on US financial markets. The stock of many non-US companiestrades on US exchanges through the use of ADRs. ADRs enable US investors to buy sharesin foreign companies without undertaking cross-border transactions. ADRs carry prices inUS dollars, pay dividends in US dollars, and can be traded like the shares of US-basedcompanies.

Each ADR is issued by a US depository bank and can represent a fraction of a share, asingle share, or multiple shares of foreign stock. An owner of an ADR has the right to obtainthe foreign stock it represents, but US investors usually find it more convenient simply toown the ADR. The price of an ADR is often close to the price of the foreign stock in its homemarket, adjusted for the ratio of ADRs to foreign company shares.

Depository banks have numerous responsibilities to an ADR holder and to the non-UScompany the ADR represents.

Individual shares of a foreign corporation represented by an ADR are called AmericanDepository Shares (ADS).

Types of ADR ProgramsWhen a company establishes an American Depository Receipt program, it must decide

what exactly it wants out of the program and how much they are willing to commit. For thisreason, there are different types of programs that a company can choose.

26 Foreign Exchange

Unsponsored sharesUnsponsored shares are ADRs that trade on the over-the-counter (OTC) market. These

shares have no regulatory reporting requirements and are issued in accordance with marketdemand. The foreign company has no formal agreement with a custodian bank and sharesare often issued by more than one depository. Each depository handles only the shares it hasissued. Due to the hassle of unsponsored shares and hidden fees, they are rarely issued today.However, there are still some companies with outstanding unsponsored programs. In addition,there are companies that set up a sponsored program and require unsponsored shareholdersto turn in their shares for the new sponsored. Often, unsponsored will be exchanged forLevel I depository receipts.

Sponsored ADRs

Level I

Level I depository receipts are the lowest sponsored shares that can be issued. When acompany issues sponsored shares, it has one designated depository acting as its transferagent.

A majority of American depository receipt programs currently trading are issued througha Level I program. This is the most convenient way for a foreign company to have its sharestrade in the United States.

Level I shares can only be traded on the OTC market and the company has minimalreporting requirements with the US Securities and Exchange Commission (SEC). The companyis not required to issue quarterly or annual reports. It may still do so, but at its own discretion.If a company chooses to issue reports, it is not required to follow US generally acceptedaccounting principles (GAAP) standards and the report may show money denominations inforeign currency.

Companies with shares trading under a Level I program may decide to upgrade theirshare to a Level II or Level III program for better exposure in the United States markets.

Level II (listed)

Level II depository receipt programs are more complicated for a foreign company. Whena foreign company wants to set up a Level II program, it must file a registration statementwith the SEC and is under SEC regulation. In their filings, the company is required to followGAAP standards.

The advantage that the company has by upgrading their program to Level II is that theshares can be listed on a US stock exchange. These exchanges include the New York StockExchange (NYSE), NASDAQ, and the American Stock Exchange (AMEX).

While listed on these exchanges, the company must meet the exchange’s listingrequirements. If it fails to do so, it will be delisted and forced to downgrade its ADR program.


Level III (offering)

A Level III depository receipt program is the highest level a foreign company can have.Because of this distinction, the company is required to adhere to stricter rules that are similarto those followed by US companies.

Setting up a Level III program means that the foreign company is not only taking someof its shares from its home market and depositing them to be traded in the US; it is actuallyissuing shares to raise capital. In accordance with this offering, the company is required toadhere to GAAP standards. In addition, any material information given to shareholders inthe home market, must be filed with the SEC.

Foreign companies with Level III programs will often issue materials that are moreinformative and are more accommodating to their US shareholders because they rely onthem for capital. Overall, foreign companies with a Level III program set up are the easiest onwhich to find information.

Restricted programsForeign companies that want their stock to be limited to being traded by only certain

individuals may set up a restricted program. There are two SEC rules that allow this type ofissuance of shares in the US Rule 144-A and Regulation S. ADR programs operating underone of these 2 rules make up approximately 30% of all issued ADRs.

SEC Rule 144-A

Some foreign companies will set up an ADR program under SEC Rule 144(a). Thisprovision makes the issuance of shares a private placement. Shares of companies registeredunder Rule 144-A are restricted stock and may only be issued to or traded by QualifiedInstitutional Buyers (QIBs).

No regular shareholders will have anything to do with these shares and most are heldexclusively through the Depository Trust and Clearing Corporation, so the public often hasvery little information on these companies.

Critical Stages in the Process of ADRs Issue

1. The company shall present its accounts in conformity with US GAAP. US GAAPrequires presentation of consolidated financial statements.

2. Appointment of legal experts, lead experts, lead managers, investment bankers andtheir due diligence.

3. Preparation of the offer document and its inspection by legal advices.

4. Filling of the offer document and its review by the Securities and ExchangeCommission (SEC).

28 Foreign Exchange

5. Replying to the comments of SEC and obtaining its clearance.

6. Roadshows and book running.

7. Appointment of domestic and international depository. Domestic depository will actas a custodian of the underlying shares.

8. Selection of an American Stock Exchange.

9. Allotment of underlying shares and creation of ADRs.

10. Listing of ADRs on American Stock Exchange.

11. Listing of underlying shares with domestic exchange.

The Benefits of Depository Receipts (DR)The DR functions as a means to increase global trade, which in turn can help increase

not only volumes on local and foreign markets but also the exchange of information,technology, regulatory procedures as well as market transparency. Thus, instead of beingfaced with impediments to foreign investment, as is often the case in many emerging markets,the DR investor and company can both benefit from investment abroad. Let’s take a closer alook at the benefits:

For the Company

A company may opt to issue a DR to obtain greater exposure and raise capital in theworld market. Issuing DRs has the added benefit of increasing the share’s liquidity whileboosting the company’s prestige on its local market (“the company is traded internationally”).Depository receipts encourage an international shareholder base, and provide expatriatesliving abroad with an easier opportunity to invest in their home countries. Moreover, inmany countries, especially those with emerging markets, obstacles often prevent foreigninvestors from entering the local market. By issuing a DR, a company can still encourageinvestment from abroad without having to worry about barriers to entry that a foreigninvestor might face.

For the Investor

Buying into a DR immediately turns an investors’ portfolio into a global one. Investorsgain the benefits of diversification while trading in their own market under familiar settlementand clearance conditions. More importantly, DR investors will be able to reap the benefits ofthese usually higher risk, higher return equities, without having to endure the added risksof going directly into foreign markets, which may pose lack of transparency or instabilityresulting from changing regulatory procedures. It is important to remember that an investorwill still bear some foreign exchange risk, stemming from uncertainties in emerging economiesand societies. On the other hand, the investor can also benefit from competitive rates the USdollar and euro have to most foreign currencies.


ConclusionDR give the opportunity to add the benefits of foreign investment while bypassing the

unnecessary risks of investing outside your own borders, you may want to consider addingthese securities to your portfolio. As with any security, however, investing in ADRs requiresan understanding of why they are used, and how they are issued and traded.

TRENDS AND PATTERN OF EURO ISSUES – INDIAN EXPERIENCE

Strategic with the maiden issue of the Reliance Industries in May 1992, around 100-oddIndian companies have so far tapped the global market with a cumulative mobilization of` 99,207 crore by the end of 2004-05 through 162 issues (Table – 1.1). Indeed, India has thedistinction of issuing the maximum number of Depository Receipts (DRs) among the emergingeconomies. The genesis of Indian multinational corporations (MNCs) with not onlyinternational operation, but also a global ownership is logical fallout of this process.

While bunching of Depository Receipt issues took place in the early 1990s possibly in viewof the pent-up overseas demand for Indian scrips, it seemed to have been primarily motivated bythe existing costly procedure of flotation in the Domestic market. Initially GDRs were the preferredmode with the majority of listings in the Luxembourg or the London Stock Exchange in view oftheir less stringent disclosure requirements vis-a-vis the requirement under the US GAAP (GenerallyAccepted Accounting Principles). Besides, a majority of the Indian GDRs were issued pursuant tothe US Rule 144A, and/or Regulation of the US Securities Exchange Commission, which enabledtheir trading in the US market too mainly through the PORTAL system. Nevertheless, ADRshave since emerged as the star attraction through its higher global visibility, particularly for thenew-economy stocks. While ownership pattern of Indian GDR/ADR is not clear, both individualand foreign ownership were in general, found to be higher in London than in the US as per theParis – bases World Federation of Exchanges (FIBV) Survey (1999).

The lowest and highest numbers of Euro issue are recorded in the year 1992-93 and1994-95 respectively.

The lowest and highest amounts of Euro Issues are witnessed in the year 1992-93and 2000-01 respectively.

The highest number and amount of Euro Issues are recorded in different years. Fromthis observation, we can say that the highest numbers of Euro Issues are notnecessarily to contribute the highest amount and this is depending on the size ofcapital offered by the companies at that time.

The annual growth rate in number and amount of Euro Issues were witnessed greaterfluctuation. These fluctuations are highlighted because of various resons like, stepstaken by the Government from the time to time, rate of growth/expansion of individualcompanies and their ambition to raise funds from overseas, etc.

The last two years of the study witnessed the positive growth rate in number as wellas amount of Euro Issues. This is because of the companies permitted to make EuroIssues are broaden by the Government of India.

30 Foreign Exchange

Table 1.1: Euro Issue by Indian Companies

( ` crore)

Year No. of Issues Annual Growth Rated Amount Raised Annual Growth Rate

1992-93 2 - 754 -

1993-94 29 1,350.0 7,986 959.2

1994-95 34 17.2 7,901 -1.1

1995-96 8 -76.5 2,573 -67.4

1996-97 12 50.0 5,679 120.7

1997-98 3 -75.0 1,103 -80.6

1998-99 2 -33.3 18,097 1,540.7

1999-00 6 200.0 3,989 -78.0

2000-01 9 50.0 28,354 610.8

2001-02 3 -66.7 2,193 -92.3

2002-03 7 133.3 910 -58.5

2003-04 14 100.0 4,561 401.2

2004-05 33 135.7 15,107 231.2

Total 162 1,748.7 99,207 3,486.0

Average 12 137.3 7,631 268.2

Source: CMIE Capital Market Special Issues 2002, 2003, 2004 and 2005

Quasi InstrumentsThese instruments are considered as debt instruments for a time period and are converted

in to equity at the option of the investor (or at company’s option) after the expiring of thatparticular time period. Warrants can be quoted as the best example of Quasi Instruments.The warrant holders can purchase an additional financial asset on or up to a future date. Inshort, these instruments are considered as debt instruments for a specified period and areconverted into equity instruments at the end of the period specified. Warrants are issuedalong with other debt instruments.

Foreign Currency Convertible Bond (FCCB)FCCBs are bonds issued to and subscribed by a non-resident in foreign currency which

are convertible to certain number of ordinary shares at a prefixed price. Euro convertiblebonds are listed on a European Stock Exchange. The issuer company has to pay interest onFCCBs in foreign currency till the conversion takes place and if the conversion option is notexercised by the investor, the redemption of the bond is alos made in foreign currency.


This is a kind of warrant which gives the user more flexibility when it comes toconversion into equity the holder need not convert it in to equity, if he feels that it may notbe profitable to him.

For e.g., A warrant gives a right to buy a share for ` 50/- on a given day. Subsequently,market price of that share goes up to ` 80/- on that day. In such a situation, the warrantholder will gain ` 30/-. If he exercises this function and buys a share but if the market price ofthe share is ` 35/-, then the warrant holder would not prefer to exercise the option of buyingthe share.

Review Questions

1. What is meant by GDR? How is it different from ADR?

2. Explain the steps involved in the issue of GDR.

3. Who are the parties involved in the issue of GDR?

4. What do you mean by foreign bonds? How are they different from Euro Bonds?

5. Explain the different types of foreign bonds.

6. Explain the different types of Euro Bonds.

7. What is meant by syndication of loans? How is a syndicate loan different from aclub loan?

8. What are the major differences between USA GAAP and Indian GAAP?

9. Explain GDR as an instrument for raising finance International Capital Market.

10. Explain the role and function of Intermediaries involved in a GDR transaction.

11. What are the various instruments available for raising short- and long-term financein International Market?

12. Explain the concept of Loan Syndication.

13. Explain the process of syndication formation, their features and benefits of Lendersand Borrowers.

14. What do you understand by GDR? What are the mechanics of GDR issue?

15. What are the advantages and disadvantages of Loan Syndication.

16. Discuss Loan Syndication procedure in India.

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